Hedge Funds - Arbitrage Strategies

Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. Consider a very simple example: Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. The futures contract is a promise to buy or sell the stock at a predetermined price. So, by purchasing the stock and simultaneously selling the futures contract, you can, without taking on any risk, lock in a $4 gain before transaction and borrowing costs.

In practice, arbitrage is more complicated, but three trends in investing practices have opened up the possibility of all sorts of arbitrage strategies: the use of derivative instruments, trading software and various trading exchanges. For example, electronic communication networks and foreign exchanges make it possible to take advantage of "exchange arbitrage," the arbitraging of prices among different exchanges.

Only a few hedge funds are pure arbitrageurs, but when they are, historical studies often prove they are a good source of low-risk, reliably-moderate returns. But, because observable price inefficiencies tend to be quite small, pure arbitrage requires large, usually leveraged investments and high turnover. Further, arbitrage is perishable and self-defeating; if a strategy is too successful, it gets duplicated and gradually disappears.

Most so-called arbitrage strategies are better labeled "relative value." These strategies do try to capitalize on price differences, but they are not risk free. For example, convertible arbitrage entails buying a corporate convertible bond, which can be converted into common shares while simultaneously selling short the common stock of the same company that issued the bond. This strategy tries to exploit the relative prices of the convertible bond and the stock; the arbitrageur of this strategy would think the bond is a little cheap and the stock is a little expensive. The idea is to make money from the bond's yield if the stock goes up, but to also make money from the short sale if the stock goes down. However, as the convertible bond and the stock can move independently, the arbitrageur can lose on both the bond and the stock, which means the position carries risk.